A stringent necessity: Addressing fiscal bubbles with fiscal rules in Central and Eastern Europe

We study the role of public debt sustainability in the implementation of national fiscal rules in 11 Central and Eastern European (CEE) countries. We ask whether episodes of unsustainable increases in public debt, i.e., "fiscal bubbles", result in a modification in fiscal frameworks in CEE economies. We first model how the costs and benefits of fiscal rules explain why politicians select different levels of fiscal stringency and, more importantly, how fiscal bubbles bolster politicians' willingness to tighten fiscal rules via the perception and social pressure channels. On the empirical side, employing a bubble detection algorithm based on recursive unit-root testing, we identify the episodes when public debt reveals explosive ("bubble-like") behaviour between 2000 and 2021. Then, using the panel fractional probit models, we find that (i) the occurrence of fiscal bubbles increases the propensity of a government to increase the stringency of the fiscal rules, which implies that CEE economies use a tightening of fiscal rules as a means for fiscal adjustment when risks of public debt unsustainability become excessive, (ii) beneficial effects of fiscal bubbles are decreasing in government effectiveness, which signals that the perception channel is likely to dominate the social pressure channel. Alternative empirical specifications and the generalized estimating equation estimation corroborate our findings.